CFA Level 1 (2009) - 2

Srudy Session 4

Cross-Reference to CFA Institute Assigned Reading #16 - Organizing Production

CONCEPT CHECKERS

1.Economic profits are zero if:

A.implicit costs equal explicir costs.

B.economic depreciation equals zero.

C. toral revenue equals rhe sum of all opportunity costs.

2.Assume thar a firm had toral revenue of $50 million and used $30 million in labor and materials to generate thar revenue. Other cosrs included $100,000

in foregone interesr. economic depreciation of $20,000, and normal profit is $65,000. Using rhis information, calculate rhe economic profit to the firm.

A.$19,815,000.

B.$19,856,000. C. $20,000,000 .

.~. \\'hich of the following sratemelHS regarding technological and economic effJcienc\" is /IIost tlCCUT"fl[i'?

A.\X'henever an acrivit}' is technologically efficient. it must he economicall:' efficient.

B.For a given ourput. a technologically efficient method uses the least amount of inpurs and an economicall\" efficient method has lowest possihle cost.

C.For a given output, a technologically efficient method uses the least amount oflabor and an economically efficient method uses the least amoun t of capital.

4.Consider two markers: one has a Herfindahl-Hirschman Index (HHI) of 500, while the other has a four-firm ratio concentrarion ratio equal to 2%. Which of the following statements most accurately describes these two markets?

A.Both markets are highly competitive.

B.The market with the HHI equal to 500 is very competitive, while the other market has a low degree of competition.

C.The market with the HHI equal to 500 has a low degree of competition, while the other marker is highly comperitive.

5.The implied rental rate includes:

A.foregone interest and normal profir.

B.economic depreciation and normal profit.

C.economic depreciarion and foregone interest.

6.An industry with a Herfindahl-Hirschman Index (HHI) of 2,800 and a fourfirm concentration ratio of 7'')% is most likely competing in which rype of market?

A.Oligopoly.

B.Monopoly.

C.Monopolistic competirion.

©2008 Kaolan Schweser

Page 61

Study Session 4

Cross-Reference to CFA Institute Assigned Reading #16 - Organizing Production

7.

8,

Which of the following is least likelyl to be used to reduce the principal-agent problem in corporations?

A. Usc of a company jet.

B. An incentive-pay system.

C. Long-term employment contracts.

Which of the following statements least flcmrately describes why firms can sometimes coordinate economic activity more efficiently than markets? Firms can achieve economies of:

A.scale.

B.scope.

e.cost.

9.Consider two manufacturing processes that can be used to produce the same

quantity of a given product. Process A uses 10 units of labor and 50 units of plwsicaJ capital. Process Buses 10 unirs of labor and 'i00 units or capital. W'hicll of rhe following /1/0SI /ll'i'ln'/lte/)' describes rhese two processes?

,'\, Process:\ is economicall:' efficienr ~tnd technological I:'erficil'nl.

B.Process B is technologically inefficient Jnd economically efficient.

C.Process A is technologicall:' efficient and either process may be economicalh' efficient.

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©2008 Kaolan Schweser

+ $65,000

Study Session 4

Cross-Reference to CFA Institute Assigned Reading #16 - Organizing Production

ANSWERS - CONCEPT CHECKERS

1.C Economic profit considers hoth explicit and implicit opportunity costs. When total revenues arc just equal to opportunity costs (explicit and implicit, including normal profit), economic profits arc zero.

') A Economic profit = total revenue - opportunity cosrs = toral revenue - (explicit +

implicit costs). In this case, the labor and material COSt of $30 million is the explicit

cost. Implicit com include the $100,000 in foregone interest, economic depreciation of $20,000, and normal profit of $65,000. So, total implicit cOSts equal $100,000 +

$20,000 = $185,000, Thus, economic profit is $50,000,000 - $30,000,000- $185,000 = $19,815,000.

5.B Technological efficiency is achieved by using the least amount of inputs to produce a

~iven output. Economic "'fficienc)' is achievcd hy producing a given output at the lowest

pmsi h Ie L'OSr.

,I, :\ ,'\11 HHI of SOUl' low, illdIL'alill~;1 Ill~h de~rl'l' 01 LOlllpcrilioll, A I'llir-linli C'OIlCL'lllratioll ratio 01'.:!"" illdic;lln.1 hii'h level of cOlll!)ctit;oll, Th" hif:her (IO\\'l'1'i[Ill'

concelHration measure. the lower (Sfeller) the degree of competition.

S.C Tht' implied I'l'lll;d ratl' includcs economic depreciation and foregon" Interes!. \'X'hen discussing economic profit. economic depreciation is the decrease in the value of an asso while thal asset IS heing: used III product' a product.

(1. A A. monopoly markct has ,J Herfindahl-Hirschman Index of 10,000 ;JnL! a fourfirm concentration ratio of 100'10. An HHI index greater than I ,BOO indicatcs an

uncornpetitive market and a four-firm ratio greater than GOO;') indicatcs an oligopolv market. Therefore, the firms in thc industrv described are most likely in all oligopoly market.

A A company jet could be a sympwm of a principal-agenc problem and does not address a divergence of incentives. The other choices are common methods to reduce the principal-agcnc problem.

R.C hrms call oftcn coordinate economic activit) more efficicntly than markets because firms can rcducc the costs of marker transactions. and they can achieve economies of scale. scope, and team production. Economies of cost is a made-up term.

9.A Process A is technologically efficiclll because for the same J() units of labor, it can produce the given oUtpUl with less capital. For am' prices or capital and labor, Proccss ;\

must havc a lower cost. so it is also the economically efficient process.

©2008 Kaolan Schweser

Page 63

The following is a review of the Economics principles designed to address the learning outcome statements set foeth by CFA Institute@. This topic is also covered in:

OUTPUT AND COSTS

Study Session 4

EXAM Focus

This review IS primarily focused on the relationship between shorr-run COStS and Outpue. You should know how rotal, marginal, and average product relate to the

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= __ 'IBlann

componenrs of rotal cose. Be able ro describe diminishing recurns ro labor and capital, and undersrand the long-run conditions that lead ro economies of scale.

The shorr run i, defined as a time period for which quantities of some resources are fixed. A firm has chosen its production methods and. if it is a manufacturer, the

machinery it will use ro produce itS produccs. In the long run, a firm can adjust its input quanrities, production methods. and plant size.

So the technology of production is fixed in the shon run and is a conscrainr on a firm's ability co iL::rease production. TypicaJly, economists creat labor and raw m<Jccrials

as variable in the shon run. holding planr size, capital equipmenr, and technolog:-' constanr. All of these facrors become variable in the long run.

Shorr-run decisions. such as adjusting labor and raw materials inputs, are easier ro reverse than long-run decisions, such as investing in new technology or capital assets. Capital that has been spenr on a long-run project is typically a sunk cost which (as we will see in the Study Session on Corporate Finance) managers should not consider when making investmenr decisions.

", .; r.1,; 1 ')"	L. ··,r,,'~·r·~:.V	.:.U.-i{: !.~_;·:~~'i(-~ir:	';'1~':-_' i:':~ial1fH~.:; arn.{jlng lor~i .product or labo)}
n~arg1.l1a::_	r-~.i :)·uu:::'-·	<;_tJ\~'::	;:"'i";"':~~» ~':·r~'t.c?ucr ()f labor; and descrih~·

In what follows, we will examine outpUt in the shan run, allowing only the quanrity of labor employed to vary.

The table in Figure 1 conrains output information fot a hypothetical maker of shins. Sam's Shins. The first column of the table lists different quanrities of workers per day that can be employed. The second column lists the rotal number of shirrs per day that Sam's can produce with differenr numbers of workers, holding planr and equipmenr constanr. This rotal output of shins is called the total product. The third column has the number of additional shirts per day from adding each successive worker. This is the marginal product of labor, the additional output from adding one more unit (in this case one worker-day) of labor. The fourrh column lists the average number of shins per

Study Session 4

Cross-Reference to CFA Institute Assigned Reading # 17 - Output and Costs

worker that are produced for each quantity of workers. This is the average product of labor. Note that the units of total, marginal, and average product are units of the good produced per unit of the input under consideration, in this case, shirrs per worker day.

Figure 1: Short-Run Output as a Function of Labor Employed

	WOI·kers	Total Product	Marginal	Am·rage
			Product	Product
		8	8	8
2		20	12	10
3		26	6	8.7
4		30	4	7.5
::;		32	2	6.4
()		33		'J. ::;

Panel (a) and panel (b) of Figure 2 show the wtal product curve and marginal product curve, respectively, for Sam's Shirrs. The total and marginal product curves in Figure 2 have been "smoothed" to account for fractional worker days. The total product curve can be viewed as a production possibilities .frontier. The area above the curve represen ts output that cannot be produced by the given number of workers. The area below the curve represents technologically inefficien t production because more labor than necessary is being used to produce each level of output.

Note that the marginal product curve shown in panel (b) of Figure 2 initially increases, reaches a peak, and then begins to decline. This behavior is typical. The marginal product curve for an input typically shows increasing marginal returns initially, and decreasing marginal returns at some point. Decreasing marginal returns describes a situation where the marginal product of an input decreases as additional units of that input are employed.

Figure 2: Total Product and Marginal Product

(a) Total product (TP)

(b)

Marginal product (MP)

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©2008 Kaplan Schweser

Page 65

Study Session 4

Cross-Reference to CFA Institute Assigned Reading #17 - Output and Costs

Figure 3 shows the relation between the average product curve for Sam's Shirts and the marginal product curve. Note in Figure 3 that average product is at its maximum at the poinr where the marginal product curve intersects ir from above. For Sam's Shirts, this intersecrion occurs between rwo and three workers per day. Note rhar for rhe second worker, MP is greater rhan AP, bur with rhree workers, MP is less than AP. This relarionship is not unique ro Sam's Shirts. Typically, marginal product exceeds average producr up ro some inpur <luantity where rhey arc equal. Beyond rhat poinr, marginal producr is less rhan average producr.

Figure 3: Average Product and Marginal Product of Labor

AI' &: MP

(shirl\ I'Ll dar I'"r worker)

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U~)S ]}.c: Distinguish ;!rJl:>l!S'			tot;]] cos:. (includ;nlC, both fixed cost and variable
cost). marginal COSf, and ,)vt:ra~:~ cosi.. and explain rhe relations among the
VCifi<JUS COSt	c::urv~s.

To increase output in the shorr run, firms musr use more labor, which increases cosr. The relationship berween output and cosr may be explained in terms of three cosr concepts:

(l) total cost. (2) marginal cost, and (3) average cosr.

Total cost, Te, is rhe sum of all cosrs associared wirh rhe generarion of output. TOlal cosr is made up of toral fixed cosr and wral 1J,zriaUe cosr.

Total fixed cost, TFC, is the cosr of fixed inputs, such as properry, plant, and equipment, plus normal profit, i.e., rhe value of rhe enrrepreneurial ability of rhe firm's owners or managers. Toral fixed cosr is independent of rhe level of rhe nrm's outpUt in the shorr run.

10tal variable cost, I'Ve.is the COSt of all variable producrion inpurs. Total variable COSl increases as outpur increases. The single biggesr variable cost for most firms is rhe cost of labor (and raw marerials for manufacturing firms).

[Otal cost = rotal fixed cost + tora] variable cosr

Figure 4 illustrares the components of total cost for Sam's Shirrs at different output levels. We will assume that Sam's fixed cosr is $20 per day ro rent one sewing machine. This amount will not change regardless of the quantity of shirtS produced. So, the TFC curve is a horizontal line at $20 per day.

Page 66

©200B Kaplan Schweser

Smdy Session 4

Cross-Reference to CFA Institute Assigned Reading # 17 - Output and Costs

For simplicity, assume that labor is the only variable cost, and that Sam pays his workers $20 per day. So total variable cost will increase by $20 as each additional worker is required to increase output. Notice in Figure 4 that the vertical distance between the TVC and the TC curves is roral fixed cost. It is also important ro note that both TVC and TC are increasing. This is because TVC increases as oUtput increases.

Figure 4: Total Cost Curves

Cost per day

120

TC

UUtput

(shins per da\')

Notice that the TC and TVC curves in Figure 4 increase at increasing rates. This can be explained through a discussion of the concept of marginal cost.

Marginal cost, MC, is the increase in	rotal coS[ for one additional unit of output. Since
the addition of each worker results in	multiple additional shirrs, we divide the change in
total cost by the increase in OUtpUt ro get the marginal cost amounts in Figure 5. That is:

.	I	change in total cost	MC	.6.TC
margll1a	cOSt =	~	, or	= --
		change in output		.6.Q

The relationships among TFC, TVC, MC, AFC, AVe, and ATC are shown for increasing amounts of labor and output in Figure 5.

©2008 Kaplan Schweser

Page 67

Study Session 4

Cross-Reference to CFA Institute Assigned Reading # 17 - Output and Costs

Figure 5: Total, Marginal, and Average Costs for Sam's Shirts

	Output	Labor	TFC			MC	AFC
				TVC		TC ($/additio/lal		AVC	ATC
	(Shirts)	(workers/day)					($/shirt)
			($/day)			shirt)
	o	o	20	0		20
						-----2.50-----
	8		20	20		40	2.50	2.50	5.00
						----1.67---0-
	20	2	20	40		60	1.00	2.00	3.00
						-----3.33-----
	26	3	20	60		80	0.77	2.31	3.08
		4				-----5.00-----
	30		20	80		100	0.67	2.67	3 ..33
		5				----10.00----
	32		20	100		120	0.63	3.13	3.75
							-----5.00-----
	TFC = Total fixed COSt			COSt of fixed		inpurs; independen t
				or oUtpUl
				eml u!·variable inputs;
				changes wilh ouepur
	TC = lotal cost						-----10.00-----
	MC = Marg.inal COSt			change in [Olal COSI for one unit			A1C = ..0I.TC / .:iQ
				!ncrease In output
	AFC = Aver;lge fixed cost						AFC = TFC / Q
	AVC = Average variable cost						AVC = TVC / Q
	ATC = Average toeal COSt						ATC = AFC + AVC

Example: Marginal cost

Using the information for Sam's Shifts presenred in Figure 5, calculate the marginal cost per shirt when output increases from 8 to 20 shirts per day.

Answer:

In Figure 5, we see that the change in TC when output increases from eight to 20 shirts is $60 - $40 = $20. Since the change in output is 20 - 8 = 12 shirts, the marginal cost can be calculated as:

MC = $20 / 12 shirts = $1.67 per shirt

Average cost is the average cost per unit of output at a given level of output. Since there are three types of costs, there are three corresponding average costs. These are:

•	Average fixed cost, AFC, total fixed cost per unit of output.
•	Average variable cost, AVC, total variable cost per unit of output.
•	Average total cost, ATC, total cost per unit of output.

Page 68

©2008 Kaplan Schweser

Study Session 4

Cross-Reference to CFA Institute Assigned Reading #17 - Output and Costs

The individual average coSts are calculated by dividing the total costs at a given level of output, Q, by that level of output. Mathematically, we have:

TC = TFC + TVC, orATC= AFC+AVC

Q Q Q

Average coStS at the various output levels for Sam's have been calculated and tabulated in Figure 5. The marginal cost (Me) and average cost (ATC, AVe, and AFC) curves for Sam's Shirts are shown in Figure 6.

Figure 6: Average and Marginal Costs

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MC

53

51

AFC

10

20

30

Important relationships among the marginal and average cost curves in Figure 6 are:

•AFC slopes downward. This is because fixed costs are constant but are distributed

over a larger and larger number of products as output quantity increases.

•The uertical distance between the ATC and AVC curue.' is equal to AFC. This is indicated by the arrows marked "XU at an output of 20 shirts per day.

•MC declines initially, then increases. At low output quantities, efficiencies are realized from the specialization of labor. However, as mote and more labor is added.

marginal cost increases. This is due to diminishing returns, which means that at some point, each added worker contributes less to total output than the previously added worker.

•MC intersects AVC and ATC at their minimum points. The intersection comes from below, which implies that when Me is less than ATC or AVe, respectively. ATC or AVe are decreasing, This also implies that when MC exceeds ATC or AVe, respectively, ATC or AVC are increasing.

•ATC and AVC are V-shaped. AVC decreases initially, but as output increases, the effect of diminishing returns sets in and AVC eventually slopes upward, giving the curve its V-shape. However, since fixed costs are spread out over a larger and larger quantity of output, AFC decreases as output increases, and eventually flattens out. ATC gets its U-shape because as Outpur increases we are adding a curve that goes from downward sloping to flat (AFC) to a V-shaped curve (AVC) , which results in a V-shaped ATC curve. Remember, ATC = AVC + AFC,

©2008 Kaplan Schweser

Page 69

Srudy Session 4

Cross-Reference to CFA Institute Assigned Reading #17 - Output and Costs

The relationship between product curves and cost curves is illustrated in Figure 7, where average and marginal product curves for a firm are presented in panel (a), and marginal and average cost curves are presented in panel (h). Figure 7 illustrates the following important links between a firm's product curves (technology) and its cost curves.

•Over the initial increase in labor from zero to L] in panel (a), MP and AP increase and MP reaches its maximum. Over the corresponding output range in panel (b),

MC and AVC decrease to output quantity Q1 where MC is at a minimum. Note that L j is the labor required to produce Qj'

• As labor increases from L j to L2 , and output increases from Q1 to Q2' AP conrinues to increase to a maximum at L2 and AVC conrinues to fall to its minimum at Q~.

Over this same production range, MP is declining and MC is rising.

•As labor increases beyond L2 and output increases beyond Q~, MP and AP both decrease, and MC and AVC both increase.

Figure 7: Product and Cost Curves

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LOS 17.d: Explain the firm's production function, its properties of diminishing returns and diminishing marginal product of capital, the relation between short-run and long-run costs, and how economies and diseconomies of scale affect long-run costs.

A firm's production function is the relationship between its inputs of capital and labor and the quantity of output it can produce. Figure 8 shows a possihle production function for Sam's Shirts. Notice that as the firm adds morc units of lahor or capital.

the resulting increase in output reaches a maximum and then starts to get smaller. This illustrates the fact that productive inputs exhibit diminishing returns.

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©2008 Kaolan Schweser